Callaway Golf has a Better Shot in 2002

The stock has been sliced almost in half from its 52-week high thanks in part to a lousy economy, lower discretionary spending and foul weather.

But much of what ails the Carlsbad-Calif. based maker of golf clubs, balls and accessories appears to be temporary.

"The economy in 2002 will be better than 2001, and we believe that the weather won't get any worse," says Alexander P. Paris, an analyst at Barrington Research Associates.

The analyst, whose firm does no underwriting for Callaway, says a raft of new products and intensified marketing efforts should boost results next year for the biggest U.S. seller of golf clubs.

While golf activity has been slow for some time now, Callaway doesn't need big growth in the sport to succeed. "Golf has been flat to showing 2% growth for the last ten years," says Callaway spokesman Larry Dorman.

Of course, growth would be welcome. Rounds played in the U.S. have been down in 11 of the past 12 months. "Most of the weakness in Callaway's earnings are because the macro [environment] for the golf industry has been very soft over the last year and a half," Paris says.

Last month, Callaway said third-quarter profits had fallen by 67% from a year ago. (Excluding charges, profits were down 28%.) The company also lowered projected 2001 earnings to a range of $1.01 to $1.06 per share and reduced estimated revenue to $800 million to $820 million.

But we're getting closer to 2002, when Callaway's fortunes are expected to improve.

"They're going to release a record number of new products next year," says Paris, who last month upgraded Callaway shares to Strong Buy from Long-Term Buy (after third-quarter results were announced).

Next year, Callaway, which is well known for its Big Bertha&reg; metal woods and irons, will release a C4 graphite head driver, premium CTU-30 and HX golf balls, a stainless steel metal wood and a stainless steel iron.

In the third quarter, sales of metal woods comprised 41% of sales, while irons accounted for 37% of revenues.

The ball business, which Callaway entered last year and comprises only 6% of sales, isn't making money yet. "We're hoping in 2003 to be profitable," says Dorman, who suggests the business may break even next year.

He's looking for the release of two new premium golf balls next year, and improved efficiencies in golf ball manufacturing should boost results, too.

Almost two years ago, we cautioned that Callaway stock might come under pressure, principally because introduction of the new ball could squeeze earnings (see Weekday Trader, "Can Callaway Keep its Eye on the Ball?," November 17, 1999).

Trading at a recent 14.67, the stock is about where it was when that story ran. It's also 46% below its March 52-week high of 27.18, and 24% above its September 52-week low of 11.83.

With a market capitalization of about $1 billion, Callaway has $106 million in cash and marketable securities and no debt. It also trades at just 1.2 times sales and 1.8 times book value.

"The company has a pristine balance sheet and it's certainly relatively inexpensive," says Bruce Sherman, president and chief investment officer of Naples, Fla.-based Private Capital Management.

Sherman, whose firm held 1.55 million Callaway shares as of June 30, says his company has been adding to its position since then.

Trading at 14 times the 2001 consensus estimate of $1.02 per share and at only 12.5 times next year's $1.17 per share estimate, Callaway stock is selling below its expected 2002 and long-term annual earnings growth rate of around 15%, according to Thomson Financial/First Call.

And based on trailing-12-months earnings, it's also changing hands at less than half the multiple of the Standard & Poor's 500. The stock offers an above-market 1.9% dividend yield, and the company has a buyback plan that authorizes Callaway to repurchase up to $100 million in stock.

Separately, Callaway's founder and chairman Ely Callaway died on July 5. That day, the stock shot up 6% on speculation that a takeover was more likely.

"Callaway is a reasonable acquisition candidate," says Sherman.

"For someone like Nike that desperately wants to get into the golf business in a big way, this would be a great buy," says Paris.

"We never talk about any speculation," replies Callaway's Dorman. Nike did not return telephone calls on the subject before deadline.

One potential wild card: Callaway still is embroiled in a dispute with the U.S. Golf Association (USGA), which has banned the use of its $500 ERC II driver. The USGA asserts that the driver gives golfers an unfair advantage when hitting the ball.

Third-quarter sales of the ERC II were weaker than expected, and many club pros and personnel won't recommend the driver, notes Hibernia Southcoast Capital analyst Daniel Davila. It's unclear if and when the dispute can be settled.

But with a rock-solid balance sheet, attractive valuations and a slew of new products in the offing, Callaway's future looks pretty good. With better weather and a stronger economy next year, Callaway stock may turn out to be like a drive right down the middle of the fairway.

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